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MEASURING
"CHEAP"
Are stocks cheap now? Are they getting cheaper? How do you measure "cheap?" Gold is up 30 percent on the year. Is that expensive? What about oil? At $96 a barrel, oil prices are up 57 percent this year. Of the 30 commodities I actively follow, oil is the most expensive. However, as the legendary trader Jesse Livermore once observed, when a market is cheap or expensive, there’s probably a reason. Livermore said he always made money selling short low-priced markets—the public’s favorite—in which a large long interest had developed. Alternatively, he cashed in on expensive markets when everyone was bailing out because the public thought the market was high enough for a healthy reaction. The public was selling soybeans short at $6 a bushel in 1974 because this was an all-time high and into resistance. Who could have guessed they weren’t even halfway to what would be record highs above $13 a bushel that year? It's not the price that's important, it's the market action. The real question is: How do we analyze relative values? One method I use is to look at the ratio of one key commodity to another. For example, on Nov. 9, crude oil futures closed at $96.32 a barrel and gold futures closed at $834.70 an ounce. By dividing the price of gold by the price of oil, we see mathematically that today one ounce of gold buys 8.66 barrels of oil. How has this ratio performed over time? The chart below illustrates the relationship. Gold/Oil 1985-Present
Source: Commodity.comAt 8.66, this ratio is historically low. That makes gold cheap in relation to oil despite the fact gold is up 30 percent this year. The lowest this ratio has been in recent history was 6.3 during the summer of 2005. (In August 2005, oil was $69 a barrel; gold was $435 an ounce.) The ratio high was 32.5 in July 1986, when oil was only $11 a barrel and gold was $357 an ounce. Looking at the history of this relationship, the mean (or average) was about 20-to-1. In other words, if oil remains at $96 a barrel, gold should be trading 20 times higher at $1,920 an ounce. What about other relationships? Silver closed at $15.54 an ounce on Nov. 9. One ounce of gold today buys 53.7 ounces of silver. The chart below shows how this relationship appears historically. Silver/Gold 1985-Present
Source: Commodity.comContrary to what you may have been thinking, this chart indicates silver is expensive in relation to gold; the range has been a low of 45 and a high of 99. The average has been about 75, so if this ratio returns to a norm and gold prices remain at $835 an ounce, then one ounce of gold should buy 75 ounces of silver at about $11 per silver ounce. With $15.50 an ounce silver and a 75 ratio, gold should be worth $1,162 an ounce. What about stocks? The chart below illustrates the ratio of the Dow to gold. It's currently 15.6, which means the Dow buys 15.6 ounces of gold. In 1999, this ratio was 42-to-1 (stocks were expensive) and it was less than 4-to-1 in 1987 right after the stock crash (stocks were cheap). Dow/Gold 1985-Present
Source: Commodity.comWhat if the Dow dropped to 11,500 again--where it was just one year ago--and this ratio moved back to 4-to-1, indicating cheap stocks? Gold would then be valued at $2,875 an ounce. There certainly are endless ways we can play with these ratios. While $2,000 an ounce or higher for gold may seem outrageous today, these prices don't appear to be so out of line in light of historical relationships. Of course, these are dynamic markets, and oil prices could certainly tumble, with gold remaining at its current levels. Or maybe the Dow will move back up. However, my sense is an economic downturn is coming, stocks are moving lower, and although oil may not move much higher, it's not going to collapse either. By performing this exercise, we can view the markets from new perspectives and imagine incredible possibilities. And it certainly makes gold look cheap.
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